Gilles Saint-Paul, a graduate of Ecole Polytechnique in Paris, obtained his Ph.D. from MIT in 1990. Since then he has worked on issues related to unemployment, long-term economic growth, political economy and European Labor market institutions. He has published extensively on these issues, in particular Dual Labor Markets: A macroeconomic perspective (MIT Press, 1996) and The political economy of labour market institutions (Oxford University Press, 2000). His recent work has dealt with the implications of new technologies and intellectual property rights for growth and the dynamics of income distribution. He is Programme Director of the Centre for Economic Policy Research in London in the area of Labour Economics, as well as CEPREMAP in Paris.

THESE issues have been much discussed by economists. Traditional income support schemes subject to resource conditions typically create bad incentives for taking up work. Minimum wages also destroy jobs by reducing the incentives to hire. For those reasons, governments have tried to implement systems by which they would supplement labour income for low wage earners. But these subsidies have to be phased out as the individual's earnings go up, otherwise they could not be financed. Therefore the inevitable price to be paid is higher marginal tax rates for those workers that find themselves in the region of the distribution of income where the subsidy is being phased out. And of course the issue is compounded by the fact that to finance the income support, the tax burden has to be increased on other categories of workers.

INFLATION would certainly deflate the real value of public debt in most countries. It would also reduce real interest rates, inducing people to spend more so as to get rid of their nominal assets, and may also reduce the cost of labour to the extent that workers have nominal wage contracts.

Yet this would be just a short-term fix and it would not address the structural problems. We have learned in the seventies that inflation only works if it is unanticipated. Otherwise it is reflected in higher nominal interest rates (notably on public debt) and in indexed wage contracts. As it is difficult to fool people more than once, after such a surprise inflation can then easily crawl into the two-digit zone and disinflation may be quite costly: to stop inflation the Fed had to plunge the US economy into a recession in the late seventies/early eighties.

TO ME the real mystery is that the euro seems much more costly than what its opponents thought when it was introduced. It seems to have generated perverse dynamics that make it eventually unsustainable. I believe several aspects are involved here.

First of all, inflation differentials accumulate over time. Spain, Portugal and Greece have an overvalued real exchange rate. This depresses their growth prospects and makes it more difficult for them to solve their budget crisis while remaining in the euro zone. The mystery is: why did not we see any correction mechanism for those imbalances?

The answer is that by being in the euro zone, these countries could finance those imbalances by borrowing abroad at a low real cost. This allowed Spain to finance a large trade deficit, and Greece and Portugal to finance both a trade and a budget deficit. Under a floating exchange rate, more discipline is imposed by the markets: unsustainable paths are soon being punished by an attack on the currency, which tends to restore the country's competitiveness. But in the golden years of the euro the markets decided not to pay attention to country-specific developments. They believed that all euro-denominated bonds were worth the same. Thanks to the ECB's independence and the anti-inflationary nature of its mandate, they were willing to charge a low interest rate on such bonds. Thus no market discipline was imposed to correct for imbalances between real exchange rates. During the crisis the markets started to pay more attention to the euro zone and realised that these were different countries with different policies and different macroeconomic prospects. They found a number of aging societies with unsound public finances and competitiveness problems, in the context of a severe crisis, and started pricing their sovereign debt accordingly.

In the current situation the prospect of a country exiting the euro makes it a greater liability for it to remain in the euro area. The reason is that if it reverts to its former currency, having borrowed in euros, its debt burden will increase since the new currency will likely be depreciated. This in turn increases the likelihood of default. This is contrary to a country which never joined the euro and continued to borrow in its own currency: a depreciation will restore the soundness of both its external and government accounts. Compare the UK, which despite a loose monetary policy, high exposure to the financial sector, and an 8% of GDP budget deficit, borrows at 1.6% long-term, while Spain, despite its efforts at austerity, must pay more than 6%. The difference between these two numbers gives us a measure of the liability that euro membership has become.

As was the case for the famous “peso problem” of the eighties, the more the markets expect bad things to happen, the more one is tempted to give in and behave as the markets expect. Otherwise, one is paying a premium for one's deteriorating reputation without reaping the benefits of no longer having to abide by it. If high borrowing costs and poor growth prospects make default inevitable, as is the case for Greece, then the opportunity cost of leaving the euro falls, and an exit from the currency union becomes more likely. This is the scenario where the most troubled countries leave.

Another scenario is that the least troubled countries, especially Germany, might leave. What would Germany gain from leaving? First, it may avoid a high inflation regime (relative to its tastes) as the ECB will be faced with greater pressure by most member countries to monetise debts and let their value erode through inflation. Second, it will avoid the political pressure to bail out other countries based on the logically dubious argument that they share the same currency. Third, its currency will appreciate which will reduce the value of its euro-denominated liabilities. A negative side-effect is that its exports and therefore its trade surplus will fall. But since this trade surplus is large, this will actually tend to eliminate an imbalance. Furthermore, as one German commentator pointed out, what is the point of running a trade surplus if it is used to accumulate bad assets such as mortgage-backed securities and Greek debt?

THE economics of capital taxation are poorly understood by the general public, because they are in fact subtle.

A common tendency is to advocate capital taxation on the grounds of some distate for capital, perhaps because capitalists are supposedly rich (and therefore disliked), or because they do not derive their income from their labour, which means they do not suffer for it, which is supposedly immoral. In fact, capitalists are not necessarily rich, they may for example be pensioners who have invested their savings in corporate bonds or equity in order to provide for their old age. If one wants to tax the rich, say for redistributive purposes, so be it, but then one should tax wealth or income irrespective of their source.

TRADE deficits are not a problem when they are the result of temporary imbalances between investment and savings. For example, an emerging country may need to invest a lot in physical capital, and it makes little sense for it to finance this investment with a reduction in consumption. Instead, it must maintain its consumption at a reasonable level and borrow from abroad, which means running a trade deficit. Later, when it has grown richer, it will reimburse its debt by saving more than it invests, i.e. by running a trade surplus.

EMERGING countries are growing fast, which increases the demand for raw materials. Therefore, the price of raw materials goes up. This is a real phenomenon, in the sense that it is going up relative to other goods. This relative price adjustment is necessary for the world market for materials to clear. From an accounting perspective, it also shows up as more rapid growth in the consumer price index, in particular in the West. Does that mean that "inflation" is more of a problem? Yes, from an accounting perspective. No, from an economic perspective.

It is not that we expect the value of money to eventually go down more quickly as a result of the rise in import prices. If imports must be relatively more expensive, either the aggregate price index must go up, or the price index of domestic producers must fall. An important task of the central bank is to distinguish movements in the aggregate price level that result from relative price adjustments, from movements that signal a general drift in all prices. It is the latter, not the former, that central banks are supposed to combat. To do so, formulating an inflation target based on "core inflation" (i.e. domestic prices excluding imports) is enough. If my monetary policy prevents core inflation from exceeding 2%, I am preserving the value of money in the long run. If headline inflation is 2% higher than core inflation, it means we are getting poorer because of the increase in the cost of imports. There is nothing we can do about it and it does not imply that inflation is getting out of control.

INSTEAD of asking the question, "What to do with Greece?", one should instead ask the question “What policy regime should we implement with respect to insolvent countries?”.This would probably lead to improved answers to the first question.

MY ANSWER is: not a politician. The last two directors were politicians who were holding the job while in the opposition party of their own country, and who were supposed to resume their political careers after their mandate at the IMF.

WHAT we need is a device that enforces fiscal stability over the long term, while not constraining the short term. The budget should be balanced over time, not on a period-per-period basis. This is because (i) deficits and surpluses are useful in stabilising macroeconomic activity and (ii) tax rates should be smoothed over time in order for the tax system to be efficient.

I TEND to agree with Eichengreen and co-authors. There is an easy source of catch-up which consists of accumulating capital and importing technologies. But this will not buy you total convergence to Western levels. At some point other factors will kick in, such as the cost of doing business, barriers to entry, transparency of the legal system, shareholder protection, and financial markets regulation and development, and none of these aspects are particularly supportive in China. As Chinese workers become more productive, but also more expensive, through the mechanism of capital accumulation and technical catch-up, production of low-cost commodity goods will gradually move toward cheaper countries, while China will produce more technologically advanced goods. Eventually it will settle at a level of GDP per capita which will be lower than in the West, but not by an order of magnitude.